Interest rates, the yield curve and the Fed chasing a phantom (lagged) threat

– by a New Deal Democrat

There’s been a lot going on with interest rates over the past few days.

Mortgage rates have increased over 7%:

This is the highest rate since 2008. Needless to say, if it continues for any length of time, it will hurt the housing market further.

The yield curve is almost completely inverted from 3 years ago (bottom left bar; top bar shows a similar curve in April 2000, 11 months before the 2001 recession):

As of this morning, the curve is typically tilted from the Fed’s 3.12% interest rate up through the 3-year Treasuries, which are yielding 4.22% (which, as an aside, is a highly palatable temptation to buy mid-maturity bonds). Also, with the exception of 20-year Treasuries, any longer maturity carries a progressively lower yield. If this is like almost all recessions of the last half century, the short end of the yield curve will completely reverse (ie Fed funds also in 2 years) before the recession actually begins. Although I won’t show the graph, the yield curve *did* invert before the last two recessions even started, immediately or shortly after the Fed started cutting rates again.

On the issue of rents, house prices and owner-occupier equivalent rent, Prof. Paul Krugman follows the fact that OER is a lagging measure. Today, he touts the monthly drop in new rental prices as a likely signal of a drop in inflation:

He’s referring to the “National Rent Index” from the Apartment List, which Bill McBride also tracks. Because it only tracks rents on new or renewed leases, it picks up increases or decreases faster than those indices that measure all rents (including those that have been renewed, eg 9 months ago).

I don’t think the index is exactly the signal Paul Krugman is making it out to be, because it’s not seasonally adjusted and rents typically decline in the last 4 months of each year:

Here is the cumulative annual index for each of the last 5 years:

The non-seasonally adjusted decrease of -0.1% in September this year was on par with 2018 and less of a decline in September 2019 or 2020. In the first half of this year, rents increased faster and accelerated , a percentage compared to 2018 and 2019. Since June, rent changes have been comparable to (and no more negative than) those two years.

I thought I’d compare the list of condos to the Case Shiller Home Price Index, below:

Note that home prices exploded year-over-year starting in late spring 2020, while apartment rents didn’t until early 2021. There were moratoriums on rent increases during the pandemic, which may have affected this comparison. Still, it is cautionary that for the limited 5-year comparison time we have, house price indices moved first.

Finally, what would the Fed have done if it had used the Case Shiller index instead of owner-equivalent rent in its “core inflation” target?

Via Mike Sherlock, Here’s What The Schiller Case Says [total, not core] CPI” looks over the last month:

Here’s another way to look at the data, comparing the monthly % changes in the Case Shiller National Home Price Index (blue), owner-equivalent rent (red, right scale) and core CPI (ie minus food and energy) ( gold, right scale):

Rent + equivalent owner rent is 40% of base inflation. Not surprisingly, core inflation tends to track similarly to OER. But between May 2021 and May 2022, OER only averaged +0.4% monthly, while the Case Shiller Index increased by 1.5% monthly average. If 40% of core inflation increased by 1.5% per month instead of 0.4% per month, core inflation would average +0.4% higher each month for the entire year.

In other words, the Fed would have had much earlier warning that the rise in core inflation would not be “transitional.”

In contrast, over the last 3 months to July when we have house price index data, OER averaged +0.4% while house prices increased +0.6% on average. This would have reduced core inflation by -0.1% each month. If we use the last two months, OER is +0.6% and house prices are flat. Core inflation would be -0.3% lower in June and July.

In fact, if the trend of the past few months continues, by the end of the year OER will be higher than house price appreciation on both an annual and monthly basis. And while OER is increasing, home price indexes are slowing.

In other words, if the Federal Reserve continues to raise interest rates, it is likely chasing a phantom threat, a lagging indicator for which leading measures will have already peaked and fallen sharply.

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